The Yuan-USD Exchange Rate and the World Economy

US president Barack Obama’s November visit to China highlighted China-US trade relations and the importance of these two major economies in leading the world out of crisis. The US president and other world leaders have charged that China is keeping its yuan currency artificially weak in order to benefit domestic exporters. An appreciating yuan, these foreign leaders feel, would bring greater balance to trade and lead the world out of the current crisis. But is this really the case? Perhaps history and a few economists can shed more light on this issue.

Those in favor of a dearer yuan include the IMF Managing Director, Dominique Strauss-Kahn. In a recent speech he emphasised the need for the global economy to shift away from the old paradigm based upon US consumption, fueled by easy credit and cheap goods from export-dominant countries. Trade surplus countries such as China must fill the consumption void left in the absence of the US. A stronger yuan is needed to increase Chinese buyers’ purchasing power abroad and to stimulate a depressed world economy.

Nobel Prize winning economist Paul Krugman is even more strident in his criticism of China’s monetary policy. He contends that China has engaged in a 'beggar-thy-neighbor devaluation' and that the nation is “siphoning much needed demand away from the rest of the world into the pockets of artificially competitive Chinese consumers” in a time of crisis. He warns that large trade imbalances, such as that between China and the US, could lead to an eventual failure in trade altogether. An appreciated yuan, he insists, is necessary to heal the world’s economic ills.

Not all agree with this sentiment. Justin Yifu Lin, chief economist at the World Bank, warns that appreciating the yuan will not help to improve global trade balances and would spoil what appears to be the beginning of economic recovery. Goods would become more expensive in the US, adversely affecting the already beleaguered American consumer. The trade deficit between the two countries would not diminish significantly because manufactured goods shipped from China are not produced domestically in the US. Mr. Lin advises instead that a growing China and a reformed US financial sector are the keys to global recovery.

Historic precedence also challenges the assertions of the likes of Krugman and Strauss-Kahn. In the 1980s the world’s major central banks worked to appreciate the Japanese yen by around 50% to the USD. The unexpected result was that the US trade deficit with Japan actually increased. The first significant decrease did not occur until 1990, five years after the central banks’ action and three years after the currency revaluation.

There is no simple short-term solution to trade imbalances. In the end, China’s monetary policy is set by China’s leaders who appear content with the yuan at around 6.82 to the USD. The result: China’s GDP once again surpassed the 8% growth rate with indications that the rest of the world is regaining its economic footing. It could be a lot worse. Debates on China's monetary policy will continue, but for now the yuan is staying put, for better or worse.